Following years of incubation, in December 2013, five U.S. regulatory agencies – the Board of Governors of the Federal Reserve System (FRB), the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (collectively, Agencies) – approved a final rule (Final Rule or Regulations) implementing the so-called “Volcker Rule” enacted in the Dodd-Frank Act. While the Volcker Rule itself comprised a mere 11 pages in the Dodd-Frank Act, the Final Rule and preamble adopted by the Agencies take up 270 pages of the Federal Register. At a basic level, the Volcker Rule is intended to limit risks to the financial system that Congress believes may be created by: (i) proprietary trading operations of insured depository institutions, foreign banking entities with certain U.S. operations, and the affiliates of the foregoing entities (collectively, banking entities) through a set of “proprietary trading restrictions;” and (ii) investments and certain relationships between banking entities and private equity and hedge funds (referred to as “covered funds”) through a set of “covered fund restrictions.”

This article provides a general overview of the Regulations as well as a discussion of related recent developments. Additional analysis of the Regulations is provided in the following DechertOnPoints:

Who Is Covered by the Regulations?

The Regulations apply to entities that fall within the definition of “banking entity,” which includes: (i) any insured depository institution; (ii) any company that controls an insured depository institution; (iii) any foreign bank that maintains a branch or agency in a State, and any company that controls such a foreign bank, as well as any commercial lending company organized under State law that is a subsidiary of a foreign bank or its controlling company under section 8 of the International Banking Act of 1978 (FBO); and (iv) any affiliate or subsidiary of any of the foregoing.1 Further, entities that are designated as systemically important financial institutions (SIFIs) by the Financial Stability Oversight Council but are not banking entities are to be subject to additional capital charges or other restrictions related to the risks and conflicts of interest that the Regulations are intended to address. SIFIs, however, are not subject to the proprietary trading or covered fund restrictions that apply to banking entities.

Restrictions on Proprietary Trading

The Regulations generally prohibit a banking entity from engaging as principal for its own trading account in any purchase or sale of one or more financial instruments. An account will be considered a trading account if the banking entity’s trading in that account: (i) involves short-term trading intent (generally less than 60 days); (ii) is subject to the market risk capital requirements; or (iii) involves purchases, or sales undertaken in connection with activity that requires a banking entity to register as a dealer, a swap dealer, or a security-based swap dealer. A financial instrument may be either: (i) a security, including an option on a security; (ii) a derivative, including an option on a derivative; or (iii) a contract of sale for a commodity for future delivery, or option on a contract of sale of a commodity for future delivery.2

Certain transactions are expressly excluded from the definition of proprietary trading. These include: (i) repos and reverse repurchase agreements; (ii) securities lending; (iii) liquidity transactions; (iv) derivatives clearing; (v) excluded clearing activity; (vi) clearing settlement or proceeding-related activities; (vii) agent, broker, or custodian transactions; (viii) employee plan transactions; and (ix) debt previously contracted transactions. Beyond the trading activities that are specifically excluded from the definition of proprietary trading, the Regulations provide for certain additional permitted trading activities, including certain underwriting, market-making and risk-mitigating hedging activities, as well as trading carried out on behalf of the banking entity’s customers.3 Such permitted activities, however, are subject to further requirements regarding material conflicts of interest and high-risk activities.

Covered Fund Restrictions

The Regulations generally prohibit a banking entity from acquiring or retaining an ownership interest in, or sponsoring, a covered fund, as a principal, directly or indirectly. Covered funds are investment funds that fall within one of three categories: (i) entities that rely on the section 3(c)(1) or 3(c)(7) exclusions from registration as an investment company under the Investment Company Act of 1940; (ii) certain commodity pools; and (iii) certain foreign funds. A range of entities are excluded from covered fund status, including:

  • foreign public funds;
  • wholly-owned subsidiaries;
  • joint ventures;
  • acquisition vehicles;
  • foreign pension or retirement funds;
  • insurance company separate accounts;
  • bank-owned life insurance separate accounts;
  • loan securitizations;
  • qualifying asset-backed commercial paper conduits;
  • qualifying covered bonds;
  • small business investment companies and public welfare investment funds; and
  • registered investment companies and business development companies.  

As with the restriction on proprietary trading, the Regulations provide for a variety of permitted covered fund-related activities, as long as certain requirements are met. Most notably, a banking entity may sponsor or invest in covered funds where it is providing bona fide trust, fiduciary, investment advisory or commodity trading services to customers. In addition, a banking entity is permitted to acquire or retain an ownership interest in, or act as sponsor to, a covered fund that is an issuer of asset-backed securities in connection with, directly or indirectly, organizing such issuer and offering its securities, and such a banking entity may engage in underwriting or market making-related activities in connection with covered fund ownership (provided, in each case, that such activities are conducted in accordance with certain specified restrictions).

Even where the Regulations permit a banking entity to retain sponsorship of or investment in a covered fund, pursuant to the exemptions discussed above, the banking entity (and its affiliates) is nevertheless prohibited from entering into certain “covered transactions” with those funds.4 The Regulations draw on the concepts found in sections 23A and 23B of the Federal Reserve Act. However, where section 23A merely places limits on covered transactions between affiliated entities, the Regulations’ so-called “Super 23A provision” prohibits such transactions altogether. The Regulations’ Section 23B provisions require that certain other transactions between a banking entity and a covered fund be substantially the same or at least as favorable to the banking entity as those prevailing at the time for comparable transactions with or involving unaffiliated companies, or in the absence of comparable of transactions, on terms and under circumstances that in good faith would be offered to an unaffiliated party.

Conformance Period

The Dodd-Frank Act provided that the Volcker Rule would take effect upon the earlier of: (i) 12 months after issuance of the Regulations; or (ii) July 21, 2012, and that banking entities would generally have two years from the Rule’s effectiveness to bring their activities into compliance. The Dodd-Frank Act also granted the FRB the authority and discretion to adopt rules to extend the conformance period by up to three additional one-year periods. On the same day the Agencies adopted the Final Rule, the FRB issued an order extending the conformance period for one year, until July 21, 2015.

Subsequent Volcker Rule Developments

Exemption for Investment in TruPS CDOs

Following the release of the Final Rule, the Agencies faced opposition concerning the Regulations’ treatment of certain trust preferred securities (TruPS CDOs). This opposition included a lawsuit filed by the American Bankers Association, which asserted that the Agencies had violated the Administrative Procedure Act in adopting a definition of ownership interest that included bank interests in TruPS CDOs. In January 2014, the Agencies approved an interim final rule permitting banking entities to retain interests in certain TruPS CDOs, provided that certain qualifications are met.

Extension of Conformance Period for Collateralized Loan Obligations

Responding to industry concerns regarding the Regulations’ treatment of certain debt interests in collateralized loan obligations (CLOs) as generally impermissible ownership interests, the FRB in April 2014 announced that it plans to provide two additional one-year extensions for banking entities to retain such CLO ownership interests.

SEC Issues FAQs to Address Volcker Rule-Related Questions

On June 10, 2014, the Staff of the Divisions of Trading and Markets, Investment Management and Corporation Finance of the SEC published guidance on the Regulations, in the form of FAQs. In the document, the Staff addressed six questions, ranging from the scope of the definition of “trading desk” to a discussion concerning the provision barring a covered fund from sharing the same name or a variation of the same name as a banking entity that organizes and offers such fund. For example, the FAQs clarified, among other things, that an entity that is formed and operated pursuant to a written plan to become a foreign public fund would be excluded from the definition of a covered fund (thus receiving the same treatment as similarly-situated registered investment companies and business development companies).